Chapter 4: Accounting Systems

An accounting system is the methods and procedures for collecting, classifying, summarizing,
and reporting a business’s financial and operating information. The accounting system for most
businesses is more complex. Accounting systems for large businesses must be able to collect,
accumulate, and report many types of transactions.

Accounting systems evolve through a three-step process as a business grows and changes. The
first step in this process is analysis, which consists of (1) identifying the needs of those who use
the business’s financial information and (2) determining how the system should provide this
information. In the second step, the system is designed so that it will meet the users’ needs. This
system included a chart of accounts, a two-column journal, and a general ledger. Finally, the
system is implemented and used. Once a system has been implemented, feedback, or input,
from the users of the information can be used to analyze and improve the system.

Components of an accounting system

There are five basic elements of an accounting system. These are:
Source Documents: provide the basic information to be processed by the accounting system.
Invoices from suppliers, bills sent to customers, and payroll records are some examples of source
documents. You have already seen their meaning and importance in previous chapter.
Input Devices: capture information from source documents and enable its transfer to the
information-processing component of the system. Journal entries, both paper based and
electronic are a type of input devices.
Information Processors: An information processor is a system that interprets, transforms and
summarizes information for use in analysis and reporting. The information processing in an
accounting system can be manual or computerized. Now a days, computer are being increasingly
used to process information.
Information Storage: After being input, processed data are usually saved for use in future
analysis or report. Information storage is the component of an accounting system that keeps data
in a form accessible to information processors.
Output Device: are the means to take information out of an accounting system and make it
available to users. Output devices include printers, and monitors, which provide such outputs as
financial statements, bills to customers and internal reports.

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Fundamental principles of accounting systems
Relevance Principle: The information that an accounting system provides should be relevant to
decision makers. This means, an information system should be designed to capture data that
make difference in decision. To ensure this, it is important that all decision makers, be
considered when identifying relevant information for disclosure.
Compatibility Principle: The compatibility principle requires that an accounting system
conform to the company’s activities, personnel and structure. The system must also be
customized to the unique characteristics of the company.
Flexibility Principle: Accounting information systems must be flexible to adjust to changes in
the company, in the business environment and needs of decision makers. These changes can be
technological developments, consumer tastes or company activities. A system must be designed
to adapt to these and other changes.
Cost-Benefit-Principle: You wouldn’t do anything in your daily life with out first weighing the
costs and the benefits. Likewise, the benefits of performing an activity in an accounting system
should be greater than its costs.
Control Principle: Any accounting information system should allow managers to control and
monitor business activities. To achieve this, accounting system must have internal control as an
element.

Internal controls and information processing methods are essential in an accounting system.
Internal controls are the policies and procedures that protect assets from misuse, ensure that
business information is accurate, and ensure that laws and regulations are being followed.

4.1. Manual Accounting systems

Accounting systems may be either manual or computerized. Since an understanding of manual
accounting systems assists managers in recognizing the relationships that exist between
accounting data and accounting reports, we illustrate manual systems first. Manual accounting
systems are simple to use and easy to understand. Manually kept records may serve a business
reasonably well when the amount of data collected, stored, and used is relatively small. For a
large business with a large database, however, such manual processing is too costly and time-
consuming. When a business has a large number of similar transactions, using an all-purpose
journal is inefficient and impractical. In such cases, subsidiary ledgers and special journals are

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useful. In addition, the manual system can be supplemented or replaced by a computerized
system.

Subsidiary Ledgers
An accounting system should be designed to provide information on the amounts due from
various customers (accounts receivable) and amounts owed to various creditors (accounts
payable). A separate account for each customer and creditor could be added to the ledger.
However, as the number of customers and creditors increases, the ledger becomes awkward to
use when it includes many customers and creditors. A large number of individual accounts with a
common characteristic can be grouped together in a separate ledger called a subsidiary ledger.
The primary ledger, which contains all of the balance sheet and income statement accounts, is
then called the general ledger. Each subsidiary ledger is represented in the general ledger by a
summarizing account, called a controlling account. The sum of the balances of the accounts in a
subsidiary ledger must equal the balance of the related controlling account.

The individual accounts with customers are arranged in alphabetical order in a subsidiary ledger
called the accounts receivable subsidiary ledger, or customers ledger. The controlling account
in the general ledger that summarizes the debits and credits to the individual customer accounts
is Accounts Receivable. The individual accounts with creditors are arranged in alphabetical order
in a subsidiary ledger called the accounts payable subsidiary ledger, or creditors ledger. The
related controlling account in the general ledger is Accounts Payable.

Special Journals
One method of processing data more efficiently in a manual accounting system is to expand the
all-purpose two-column journal to special journal. Each special journal is designed to be used
for recording a single kind of transaction that occurs frequently. For example, since most
businesses have many transactions in which cash is paid out, they will likely use a special journal
for recording cash payments. Likewise, they will use another special journal for recording cash
receipts. Special journals are a method of summarizing transactions, which is a basic feature of
any accounting system.

The format and number of special journals that a business uses depends upon the nature of the
business. The transactions that occur most often in a small- to medium-size service business and
the special journals in which they are recorded are as follows:

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Revenue Journal: is used only for recording fees earned on account. Cash fees earned would be
recorded in the cash receipts journal.
For example:

These transactions could be recorded more efficiently in a revenue journal, as shown bellow. In
each revenue transaction, the amount of the debit to Accounts Receivable is the same as the
amount of the credit to Fees Earned. Therefore, only a single amount column is necessary. The
date, invoice number, customer name, and amount are entered separately for each transaction. At
the end of each month, the amount column of the revenue journal is totaled. This total is equal to
the sum of the month’s debits to the individual accounts in the subsidiary ledger. It is posted in
the general ledger as a debit to Accounts Receivable and a credit to Fees Earned.

Cash receipts journal: All transactions that involve the receipt of cash are recorded in a cash
receipts journal.
Purchase journal: is designed for recording all purchases on account. Cash purchases would
be recorded in the cash payments journal.

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Cash payments journal: The special columns for the cash payments journal are determined in
the same manner as for the revenue, cash receipts, and purchases journals. The determining
factors are the kinds of transactions to be recorded and how often they occur. The cash payments
journal has a Cash Cr. column.

The all-purpose two-column journal, called the general journal or simply the journal, can be
used for entries that do not fit into any of the special journals. For example, adjusting and closing
entries are recorded in the general journal.

4.2. Computerized Accounting systems

Computerized accounting systems have become more widely used as the cost of hardware and
software has declined. In addition, computerized accounting systems have three main advantages
over manual systems. First, computerized systems simplify the record-keeping process.
Transactions are recorded in electronic forms and, at the same time, posted electronically to
general and subsidiary ledger accounts. Second, computerized systems are generally more
accurate than manual systems. Third, computerized systems provide management current
account balance information to support decision making, since account balances are posted as the
transactions occur.

In a computerized system, special journals typically are not used. Instead, transactions are
recorded in electronic forms, which are automatically posted to affected accounts at the time the
form is completed. In a manual system, the controlling account balance can be reconciled to the
sum of the individual customer account balances to identify any posting and mathematical errors.
The computer, however, does not make posting and mathematical errors. Thus, there are no
month-end postings to controlling accounts. Controlling accounts are simply the sum of the
balances of any individual subsidiary account balances.